The relationship between the output gap and excess liquidity: Evidence from Czech Republic, Estonia and Kosovo

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Aim/Purpose – Banks in European Transition Economies are proportionally lending less than their counterparts in the eurozone in the face of seemingly profitable loan opportunities, whilst apparently continuously holding excess liquidity. The question that arises is whether banks in European Transition Economies are holding excess liquidity that widens the output gap?
Design/methodology/approach – Given its endogenous nature, the relationship be-tween the output gap and excess liquidity is estimated using Seemingly Unrelated Re-gressions method. The research sample covers three European Transition Economies for the period 2004Q1 – 2013Q4.
Findings – The results indicate that rather than being in a causal relationship, excess liquidity and the output gap are found to be correlated via common observed and un-observed determinants.
Research implications/limitations – The most important policy implication of this research is that since the relationship between output gap and excess liquidity is not causal, reducing excess liquidity will not necessarily lead to a smaller (negative) output gap. There seems to be no straightforward policy framework informed by a clear trans-mission mechanism from excess liquidity to output gap.
Originality/value/contribution – This study is novel in two respects. Firstly, assuming endogeneity, a new conceptual relationship between output gap and excess liquidity is presented. Secondly, empirical evidence is presented using the system equation method Seemingly Unrelated Regression, not previously used in this context.